How to escape THE DEBT TRAP

If you are saddled with too many loans, go through this road map for a debt-free future

 Ayear ago, Pune-based businessman Shubho Mukherjee and his wife Debapriya were a bundle of nerves. Apart from their home loan, the couple was repaying a car loan and two personal loans. The situation turned from bad to worse when Shubho started using the plastic in his wallet not only for purchases but also to withdraw cash. "With four EMIs, our monthly expenses were higher than my income, so I resorted to credit card borrowing," he says. With more debt and fatter credit card bills, the Mukherjees began digging a deeper pit for themselves every month. 

    However, the pit has filled out shockingly well within a year. The Mukherjees' credit card dues have been paid, the personal as well as the car loan are also over. All that remains is a manageable home loan of about 15.8 lakh. This incredible conversion was brought about with professional help; a strategy had to be devised to pay off their debt. 
    A squeaky clean borrowing record has become important today. Credit information organisations such as the Credit Information Bureau (Cibil) and Experian track the credit history of an individual and pass it on to banks and credit bureaus assign 35% weightage to your repayment record while drawing up your credit score. If you have a poor record, you may not be able to take a loan. You may even find your credit card limit pruned, if not completely blocked. 
How bad is the problem? 
Your first step should be to know how you are placed. A lot of people don't even know they are headed for a debt trap. By the time they realise this, they are already trapped. Mumbai-based financial planner Gaurav Mashruwala suggests you check your income-expense ratio. If over 45% of your income is going into paying EMIs, it's a cause for concern (see graphic). 
    However, not all debt is bad. Loans taken to build assets or enhance skills are good loans and will only add to the net worth of the individual. The red light should flash if over 25% of your income is going towards the payment of EMIs of non-mortgage loans and discretionary spending. 
    Does this mean you can binge on good debt? Not really. Too much good debt is also not advisable. Almost 68% of Mumbai-based IT professional Kiran Shetty's income used to be gobbled up by his EMIs. A large chunk of this was the home loan EMI, a good debt, because it built an asset for Shetty. However, the bank turned down his car loan application because he was already paying EMIs worth two-thirds of his net income. 
Getting out of the trap 
Knowing the problem is only the first milestone in this journey. The Mukherjees came out of the debt trap after they approached a debt counselling centre. A counsellor listened to their problem and then suggested a strategy. 
    Don't think that the debt counsellor will wave a magic wand and your debts will vanish into thin air. Careful planning and a disciplined attitude will help you find your way out. It won't be an easy journey and you might have to make certain lifestyle changes and sacrifices. But, eventually, you will realise that being debt-free can make a material difference to your life. Here's your roadmap to debt nirvana: 
Prioritise debt repayments: Make a list of all your outstanding loans and then decide which of these you need to get rid of first. "Move from the costliest loans to the cheapest," says financial planner Kartik Jhaveri. Credit card rollovers are the most expensive loans, with interest rates as high as 40% a year. You should get these off your back first. If you find it difficult to pay a huge balance at one go, ask the credit card company to convert it into a personal loan. Most companies are willing to let customers pay large amounts in 6-12 EMIs. If the sum is too big, they may even extend the payment to 24 months. Such personal loans are costly, with interest rates of 15-18% a year, but this amount will be lesser than that paid while rolling over the balance. The Mukherjees used this facility to repay their huge credit card bill. 
    Next in the line of fire should be personal loans. They are costly, with interest rates of 18-24%, and should be repaid as early as possible. Take the loan tenure into consideration while making the prepayment. The lender may charge a prepayment penalty of 1-2% of the amount, but it will be worth it if you have more than 6-12 EMIs to repay. If the loan is ending in 2-3 months, a premature repayment may not be a good strategy. 
    Some loans may seem costly, but the tax benefits they offer bring down the effective cost for the borrower. The interest paid on an education loan, for instance, is fully tax-deductible. If you factor in the tax benefits in the 30% tax slab, an education loan that charges 12% effectively costs 8.5%. This is not such a bad deal at a time when interest rates on fixed deposits are hovering at 9-9.5%. Similarly, home loans offer tax benefits that bring down the actual cost of the borrowing. There's no pressing need to end such tax advantageous loans. 
Consolidate debt: If some loans are cheaper, it makes sense to use them to bring down your interest cost. Borrowing to repay a debt may seem like a zero-sum game, but you can gain if the new loan is at a lower rate. A loan against property, for instance, is available at 16-17% although there are no tax benefits. Even so, this is cheaper than a personal loan or a credit card rollover. You can also get loans against other assets, such as insurance policies, bonds and other securities. The lender will keep these investments as collateral for the loan. "Policies that are over 15 years old can be used to avail of loans to get rid of your credit card dues and other high-cost loans," advises Jhaveri. 
A word of caution here: if you are not disciplined, the new loan will only add to your problems instead of solving them. The loan against property will provide a lot of liquidity, but if the money is used to buy a new car or go on a holiday, you will be digging a deeper hole for yourself. 
Liquidate investments: The stock market has been on a roll lately. Ditto for gold, which has witnessed a sharp rise in price over the past 2-3 years. However, analysts feel that the stock market may consolidate now. Gold may not see a correction, but can come handy for raising cash. If you have stock investments or gold holdings, it may be a good opportunity to book profits and use the proceeds to bring down your debt. 
    Similarly, you can liquidate other low-yield investments to pay off high-cost debt. However, don't do this in a haphazard manner. Mashruwala advises that you first sell investments where the yield is lower than the interest you are paying. If the interest rate on your bank fixed deposit is 7-8%, while your personal loan interest rate is 15%, it makes sense to knock off the FD to repay the loan. The Mukherjees used this logic to get rid of some of their debt. "Since my chit fund investments were yielding 10% on an average, I prematurely withdrew them and paid two personal loans that had higher interest rates," says Shubho. 
    The balance in your PPF account can also be a good source of cheap funds. You can take a loan against the balance after the third year and make partial withdrawals after the sixth year. You can withdraw up to 25% of the balance subject to rules. Similarly, you can withdraw from your Ulip investments. Unlike the redemption of mutual funds and selling of stocks, Ulip withdrawals will not have any tax implications. 
Cut down expenses: No pain, no gain. If you want to effectively cut down on your debt, you also need to make some lifestyle changes. These can range from elementary measures like cutting down on dining out to more drastic steps like moving to a smaller house or downgrading to a smaller car. Of course, you cannot completely stop indulging in some recreational activity. Also, do not compromise on mandatory expenses such as children's school fee or basic food and living expenses. Even so, you can cut down on several other expenses. ET Wealth estimates that a middle class family can save up to 1 lakh a year (see table).